3 Financial Ratios Every Investor Should Know
The goal for every investor is to find the goose that laid the golden eggs: an undervalued company with cheap shares. The question is, how do I know if a stock is cheap or expensive, or which company is most likely to be profitable in the long run?
We are going to explain, with simple examples, three financial ratios that can help you to compare companies, looking at their share price, profitability and risk for the future.
The decision
Imagine you live in a town that is a small version of a financial market. You have your eye on two businesses in which you could invest. One is Ana's bakery and the other is Pedro's ice cream parlour. They are both selling shares of their businesses to increase equity. Ana wants to enlarge her shop and add to it a café and patisserie, and Pedro wants to invest in research for new flavours and open new stands in several swimming pools.
Ana divided her bakery "La Boulangerie" into 1000 shares for €40 each. She kept 250 for herself and put 750 up for sale. Her croissants are so delicious that there are always queues to buy them. As a result, word has spread among investors that her profits are going to be very good. So she not only managed to sell all the shares months ago but now they are being resold for €60.
On the other hand, Pedro decided to sell 1500 shares of his ice cream parlour "Gelato & Co" for €35 each. The weather forecast says temperatures are going to be very high this summer, so investors believe that people are going to eat a lot of ice cream, and the business is also going to do well. So the ice cream parlour's shares went up to €45.
Now, which stocks should you buy?
Price to earnings ratio
The P/E ratio can be useful to compare them. We just need to know the earnings per share the company had over the last 12 months or its net income (earnings after expenses and taxes).
Anna has made a profit of €20,000 over the last year. Out of it, she has paid €1,000 in taxes, €4,000 in costs of production, and €6,000 in dividends. So the net profit is €9,000, which makes the earnings per share €9. Pedro managed to make €7,500, which is €5 per share. Bearing in mind that the formula for this ratio is:
In the case of Ana's bakery, the P/E Ratio is 6.6 (60/9), and for the ice cream parlour, it is 9 (45/5).
The lower P/E ratio of the bakery can mean two things: the company is undervalued and therefore a better investment, or investors believe that the company will lose value. In turn, the higher P/E could mean that the company is overvalued, or that investors expect higher profits in the future, so they do not mind paying higher prices now.
We would need to look at more data to decide which company will do better in the future. But for now, we can compare their returns. We know Ana gave out €6,000 in dividends, which is €6 per share. Pedro gave out a little less, only €4 per share.
You would need 10 years of dividends to recover your investment in La Boulangerie, and 9 for Gelato & Co., so you’d make your money back quicker with Pedro. But here we are assuming that the dividends remain stable from year to year, which, as you know, only happens with bonds.
Enterprise value / EBITDA
Now let’s go one step further. EV/EBITDA is similar to the P/E ratio because it relates the value of a company to its earnings, but it is more accurate. What is the difference? It doesn’t only value the company by its market capitalisation, but also by its debts, and not only count as the net income but all the earning before paying interests on loans, taxes and deducting some assets’ depreciation and amortisation.
EV/EBITDA stands for Enterprise Value / Earnings Before Interest, Taxes, Depreciation, and Amortisation. Its formula seems long, but it is simple.
We’re going to add some debt to Ana and Pedro’s situation. Ana took out a €10,000 loan to get the bakery started. Later, she took out a short-term loan to buy a new fridge, for €1,500. The €10,000 she’s going to pay off over 5 years, while the €1,500 she expects to pay off by the end of the year.
You can get an idea of the EV or value of the company if you think of the amount of money you would need to have to buy every single share in Ana’s bakery, and pay off its debt. You would need to pay the market capitalisation (€60,000) and the short and long term debt (€1,500 + €10,000), but from that amount, we can deduct the current cash (€9,000). The EV of La Boulangerie is €62,500.
There are several formulas for EBITDA. The easier one is calculated by taking the total revenue from bakery sales and reducing the costs of goods sold (expenses such as ingredients or packaging) and operating expenses (workers' wages, bills, etc.), and adding back depreciation and amortisation. Depreciation and amortisation are losses in the value of a company's assets. They estimate, for example, how long the machines Ana and Pedro use to make their croissants and ice cream will last. They are subjective amounts decided by the management of the company.
La Boulangerie made €20,000 in revenue and needed €2,000 in flour, eggs, butter and €2,000 in wages. Ana has calculated €2766 for amortization every year, as she plans to keep her equipment for 15 years. In total, the EBITDA is €18,766.
Which means our ratio comes out to:
EV/EBITDA = 62,500 / 18,766 = 3.3
The lower the EV/EBITDA, the cheaper the valuation of the company. For Pedro and Gelato & Co, the EV/EBITDA is 5.3 (we won’t go through the math, but trust us, we checked it twice). This means that, although the ice cream parlour's shares are cheaper, if we take into account its profitability, they are more expensive. You would need over 5 years of profits to make up the value of the company based on the price you paid for the shares, while you only need a bit more than 3 for Ana.
This ratio is used to compare several companies in the same sector or see the company’s evolution.
Debt-to-equity ratio
The debt-to-equity ratio is used to determine the financial leverage of the company. It is calculated by dividing debt or liabilities by equity, which is the total value of all assets minus all the liabilities (basically, shareholder’s equity asks whether a company can cover everything it owes with everything it has). This data appears on the company's balance sheet. If you do not remember what liabilities or the balance sheet are, we explained them in this article.
Companies borrow money to grow. If a company's ratio is too high, it may be a risky bet. But if the ratio is too low, the company's management may be too conservative and, by not taking risks, you may not receive high returns either.
In the case of La Boulangerie, its debt is €11,500. The value of her equipment, the building, and everything else she owns, plus €9,000 in retained earnings, minus her liabilities, come out to €39,000 in equity.
That makes the debt-to-equity ratio €11,500/€39,000, which comes out to 0.29. That means very little of the company’s financing comes from debt. Good job, Ana. As a capital-intensive business, she could be taking out more loans, maybe to open a second location or to buy more ovens.
For Gelato & Co, the debt-to-equity ratio is 2.3. In Pedro’s case, the risk is much higher. Over two-thirds of his financing comes from debt.
How does this story end? Well, La Boulangerie has higher profitability and less debt, so even if the shares are more expensive and have risen more recently, it seems like a better investment. However, we need to wait and see if the investment in brand new flavours can help Gelato & Co expand to new towns.
I hope these ratios will help you decide next time you doubt whether to add croissants or vanilla ice cream to your portfolio.